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What is the Covered Call Option Strategy?
By Bajaj Broking Team
November 03, 2023
5 mins read
Derivatives
A covered call strategy is a popular investment technique used by traders and investors in the stock market. It involves holding a long position in a specific stock while simultaneously selling call options on that same stock. This strategy is known as “covered” because you own the underlying shares, which “cover” the potential obligation of the call options you’ve sold.
So what is covered call option strategy and how does it work? Here’s how it works: First, you buy a certain number of shares of a stock you believe will remain relatively stable or have modest gains. Then, you sell call options with a strike price and expiration date of your choice. By selling these call options, you receive a premium upfront from the buyer.
If the stock price continues below the strike price by the expiration date, the options will most likely expire worthless, and you will keep the premium as profit. If the stock climbs over the strike price, the buyer may choose to exercise the options, but because you hold the underlying shares, you sell them at the strike price, limiting your potential profit but still benefiting from the premium paid. This is the meaning of a covered call option strategy.
The covered call strategy can generate income through option premiums while providing some downside protection and potential for capital gains. It’s a strategy often employed by income-oriented investors looking to enhance their stock returns. However, it’s important to carefully select the stocks and strike prices to align with your investment goals and risk tolerance.
Objective of the Covered Call Strategy
The covered call strategy is designed to help you earn regular income while holding stocks in your portfolio. It works by selling call options against shares you already own. This way, you continue to benefit from stock ownership while collecting premiums from the options sold. Since you already own the underlying shares, the risk of a large loss from the short call position is reduced, making it a relatively low-risk option strategy for income-focused investors.
However, there’s a trade-off. While this approach lets you earn income, it also limits your profit potential. If the stock price rises sharply, you won’t benefit beyond the strike price of the call option sold. Still, it can be a great way to enhance portfolio returns in a stable or moderately bullish market. This strategy is particularly useful when you're willing to sell your shares at a target price or want to generate cash flow while waiting for better opportunities.
Key Aspects of the Covered Call Strategy
Now that you know what the covered call option strategy is, let's try to understand its key aspects. The covered call strategy blends stock ownership with call option writing. You continue to hold the shares, and by selling the call option, you collect a premium. This premium can provide a small cushion against minor market declines and adds to your total returns if the stock remains flat or rises moderately.
When the Stock Price Increases
If the stock price rises above the strike price of the call option, your upside is capped. That means you’ll sell the shares at the agreed price even if the market value is higher. However, you still make a profit on the rise in share price up to the strike and keep the premium. This can result in a solid short-term gain when timed well.
When the Stock Price Declines
If the share price drops, the premium you received from selling the call option helps offset some of your losses. While this doesn't fully protect you against major market downturns, it does reduce your breakeven point. That way, your overall loss is slightly softened, which is helpful when prices dip slightly.
When the Stock Price Stays Same
When the stock price doesn’t move much, the strategy still works in your favour. You keep the shares and collect the full premium from the call option. Even if the buyer doesn’t exercise the option, you still walk away with extra income. This scenario offers a steady return without having to sell your stock.
Advantages of Using a Covered Call
This strategy combines income generation with risk management. It’s ideal for investors seeking modest gains while reducing downside exposure. While it limits your upside, it provides benefits in flat or slightly rising markets.
Earning Option Premiums
Covered calls allow you to consistently earn income by collecting premiums. Many investors write these options monthly or quarterly to generate additional cash flow from existing holdings. Over time, this added income can increase your overall annual returns, especially during periods of low stock volatility.
Targets a Higher Selling Price
Let’s say you buy a stock at ₹490 and sell a call option with a ₹500 strike price for ₹15. If the option gets exercised, you sell the stock at ₹500 and also keep the ₹15 premium. That brings your total proceeds to ₹515. Even if the stock only reaches ₹505, you still receive ₹515. This makes it a useful strategy if you're willing to exit the stock at that price.
Provides Limited Downside Protection
If you earn ₹15 per share by selling the call, your effective cost basis reduces from ₹490 to ₹475. This premium acts as a buffer against small price declines. So, if the stock dips slightly, you’re cushioned. However, if the price falls sharply, the protection is minimal and doesn’t eliminate larger losses.
Who Should Use The Covered Call Option Strategy?
The covered call option strategy can be a valuable tool for certain types of investors, depending on their financial goals, risk tolerance, and investment preferences. This strategy is well-suited for the following individuals:
Income-Oriented Investors: Investors seeking to generate regular income from their investments can benefit from covered calls. By selling call options on their existing stock holdings, they can collect option premiums, which can supplement their income.
Also Read: Short Straddle Options Strategy
Conservative Investors: Those with a more conservative risk profile may use covered calls to add a layer of downside protection to their portfolios. The premiums received from selling call options can help mitigate potential losses in a declining market.
Long-Term Investors: Investors who plan to hold their stock positions for the long term and are comfortable with the idea of selling their shares at a higher price in the future may find this strategy appealing.
Owners of Blue Chip Stocks: Investors who hold stable, dividend-paying “blue-chip” stocks may employ covered calls to enhance their returns. These stocks are often considered suitable for this strategy because they tend to be less volatile.
Tax-Conscious Investors: Covered call strategies can be tax-efficient as option premiums are often taxed at a lower rate than capital gains, making it attractive for those who want to optimize their tax situation.
Experienced Options Traders: Investors with a good understanding of options trading, including call options, can make more informed decisions about implementing the covered call strategy effectively. They should have a grasp of the risks and mechanics involved.
It’s crucial to note that while the covered call strategy offers several advantages, it also has limitations. By selling call options, you cap your potential gains if the stock’s price significantly increases. Moreover, not all stocks are suitable for this strategy, and it’s important to carefully select the stocks and strike prices to align with your investment objectives. Consulting with a financial advisor or conducting thorough research before using this strategy is advisable.
Additional Read: ITM call option
When Should Investors Use The Covered Call Option Strategy?
Investors may consider using the covered call option strategy in various situations, depending on their financial goals and market outlook. Here are some scenarios in which this strategy can be beneficial:
Income Generation: Investors seeking to generate additional income from their existing stock holdings can use covered calls to collect premiums. This can be especially attractive in low-yield environments.
Neutral to Slightly Bullish Outlook: If you believe a stock’s price will remain relatively stable or experience modest gains, selling covered calls can enhance returns without the need for a strong price increase. This is particularly useful when you want to capitalize on a sideways or slightly bullish market.
Reducing Portfolio Volatility: By selling covered calls on existing positions, you can receive option premiums that help offset potential losses if the stock’s price declines. This strategy can provide a degree of downside protection.
Locking in Gains: Investors who have experienced substantial gains in a stock may use covered calls to lock in profits. If the stock price increases and the options are exercised, they sell at the agreed-upon strike price.
Tax Efficiency: Covered call premiums are generally taxed at a lower rate than capital gains, making this strategy tax-efficient, which can be advantageous for certain investors.
Portfolio Diversification: Investors can use the covered call strategy to diversify their portfolio by spreading risk across different assets, while still generating income.
However, it’s essential to be cautious with this strategy, as it caps your potential upside gains. Additionally, ensure that you thoroughly understand the options market, the specific stock you’re trading, and the risks associated with covered calls before implementing this strategy. It’s often advisable to consult with a financial advisor to determine if covered calls align with your investment objectives and risk tolerance.
Also Read: Futures Pricing
Conclusion
In conclusion, the covered call option strategy is a versatile tool for income-seeking and risk-conscious investors. It offers an opportunity to generate income, add downside protection, and potentially enhance returns while holding onto long-term stock positions. This strategy is popular amoung those who have a stable stock portfolio, are comfortable with potentially selling shares at a predetermined price, and understand the intricacies of options trading. While it has its advantages, it’s essential to recognize its limitations and carefully consider individual financial objectives and risk tolerance. Utilized prudently, the covered call strategy can be a valuable addition to an investor’s toolkit, offering a balance between income and growth.
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